taking a debt claim in the firm.14 Also, when W is low, inducing the second
best effort eM requires leaving the entrepreneur with an extra rent; therefore,
the first order condition in (i) trades off the cost of this rent with the benefit
from higher effort. When W is higher than W1 the contract in (i) does not
satisfy the entrepreneur’s IR. Clearly, for this constraint to hold, only the
payment in the high state RbH = Ψ0(e) is increased, which is equivalent to
increasing effort.
The entrepreneur’s shares of returns in the cases of failure and success
are, respectively, 0 and Ψ0(eM). This can be interpreted as a debt contract
specifying a reimbursement DM = RH - Ψ0(eM). Note that debt is always
risky, as eM < e* implies DM = RH — Ψ0(eM) > RL. Not surprisingly, the
investor’s debt claim is relatively risky for low levels of W and becomes safer
as W increases: higher levels of W imply more high-powered entrepreneur’s
incentives, which correspond to a safer claim for the investor.
3.2 Why lack of commitment yields a Coase Problem
When the investor cannot commit to deny funding to subsequent new-entrant
firms, it can be shown that the first entrepreneur does not accept the terms
of the second-best contract derived in lemma 1 above, unless his reservation
wage is very low.
Suppose the above debt contract is signed at stage 1. At stage 2 a second
entrepreneur wants to copy Firm 1’s entrepreneurial idea and produce a com-
peting product. However, Firm 2 has no funds: to enter the market it must
obtain financing from the only investor who is sufficiently informed about the
industry - that is, Firm 1’s financier.
The second entrepreneur is as good as the first one in implementing projects.
However, he is not an innovator (i.e., has no talent at discovering new projects),
which suggests his reservation wage is lower than the first entrepreneur’s one.
For simplicity, we will assume throughout that W2 = 0.15
The gross return from funding Firm 2 is:
V2 = Maxe2,RbL2,RbH2 (e2 — ∆)(RH — RbH2) + (1 — e2 + ∆)(RL — RbL2) — I2
s.t. :(e2 — ∆)RbH2 +(1 — e2 + ∆)RbL2 — Ψ(e2) ≥ 0
14For a detailed derivation of this result, see Innes (1990).
1 5 This assumption is inessential, but one needs to make some assumption about the cor-
relation between the two entrepreneurs’ reservation wages and this is the simplest. We can
interpret W2 =0 in terms of the two alternative motivations for reservation wages given in
section 2.1 above. For instance, competition to fund the second firm may be less intense
than competition to fund the first firm, e.g. because the investor learns something about the
second firm from funding the first firm, so outside banks are worried about winners’ curse
problems in competing to fund Firm 2.
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